is a rule of thumb that says that if you have the capacity to repay the
mortgage, you can afford a single-family house that costs up to two and
one-half times your annual gross income. (Annual gross income is the
amount you make before taxes are deducted.) Like other rules of thumb,
this is a general idea of how large a mortgage you can afford. But,
because it is so simple, it doesn't take into account all the
information that will help you feel comfortable with your mortgage
If you are buying a house with someone else
(spouse, parent, adult child, partner/companion, brother or sister or
other relative), you should consider your co-purchaser's earnings and
existing debts as well. Remember, if you apply for a loan with somebody
else, you and your co-borrower are both legally responsible for
repayment of the mortgage.
Your buying power depends on how much you
have available for the down payment and how much a financial
institution will agree to lend you.
Your down payment
If you are a first-time home buyer, the price
you can afford to pay for a house may well be limited by your ability to
come up with the required down payment and closing costs. If you
haven't accumulated much savings, you may want to set aside funds for a
down payment on a regular basis from your paycheck. Monies in your
checking and savings accounts, mutual funds, stocks and bonds, the cash
value of your life insurance policy, and gifts from parents or other
relatives may all be suitable sources for a down payment.
Private Mortgage Insurance
Depending on the lender and loan type, you may
be able to get a mortgage with as little as 3 percent or 5 percent down.
However, putting less than 20 percent down often means you will be
required to purchase private mortgage insurance. Private Mortgage
Insurance (PMI) helps protect the lending institution in case you fail
to make payments on your mortgage.
It is possible to get financing with 0-10% down
and not pay PMI (Private Mortgage Insurance). This is why 80-10-10
financing was created. It is called 80-10-10 because a lender provides a
traditional 80% first mortgage, a 10% second mortgage, and makes a cash
down payment equal to 10% of the home’s purchase price. The same
principle applies if the borrower can only afford to make a 5% down
payment: 80-15-5 financing is also available.
Your closing costs
In addition to the down payment, you will also
need to consider closing costs. The closing is the final step during
which ownership of the house is transferred to you. The purpose of the
closing is to make sure the property is ready and able to be transferred
from the seller to you.
Check with your mortgage professional, but if you are purchasing a property with a loan the closing costs are approximately 3.5% of the purchase price. If you are purchasing with all cash then the closing costs are generally 2 to 2.5% of the purchase price.
How much a financial institution will lend you
Apart from having available funds for a down
payment and closing costs, the other major factor limiting how expensive
a house you can buy will be how much you can borrow.
When you apply for a mortgage, the lender
will consider both your earnings and your existing debts in determining
the size of your loan. Lenders generally use the following two
qualifying guidelines to determine what size mortgage you are eligible
The amount of money you owe for mortgage
payments, property taxes, insurance, and condominium or co-op fee, if
applicable, should total no more than 28 percent of your monthly gross
(before-tax) income. This is called the Housing Expense Ratio. The
amount of money you owe for the above items plus other long-term debts
should total no more than 36 percent of your monthly gross income. This
is called the total Debt-to-Income Ratio.
Basically, lenders are saying that a
household should spend no more than about one-fourth of its income (up
to 28 percent) on housing and no more than about one-third of its income
(up to 36 percent) on total indebtedness (housing plus other debts).
Lenders feel that if they follow these guidelines, homeowners will be
able to pay off their mortgages fairly comfortably.
These lender ratios are flexible
guidelines. If you have a consistent record of paying rent that is very
close in amount to your proposed monthly mortgage payments or if you
make a large down payment, you may be able to use somewhat higher
ratios. Some lenders offer special loans for low- and moderate-income
home buyers that allow them to use as much as 33 percent of their gross
monthly income for housing expenses and 38 percent for total debt.
Don’t Despair, There is a Loan For You
When you go to apply for a mortgage, the lender
will use all the relevant data -- your income, your existing debts, the
purchase price of the house, your down payment, the interest rate on the
loan, and the cost of property taxes and insurance -- and calculate
whether you qualify to borrow the amount of money you need to buy the